In this post we will look at how income is generated in each of the four quadrants. Of course, income can be earned from a single quadrant or from a combination of quadrants, but we will look at each quadrant separately in the coming few posts. The four quadrants are named E, S, B, and I. “E” stands for Employee, “S” for Self-Employed, “B” for Business Owner, and “I” for Investor.
If you divide the quadrant of income generation in half vertically, the left side contains quadrants E and S: Employee and Self-Employed. Here, your income is considered earned income or active income. That is, for the quadrants on the left side, you get paid for the number of hours you work. The two quadrants on the left are the playing field of the poor and the middle class.
On the right side of the quadrant are Business Owner “B” and Investor “I”, where your income is considered passive income. This means that you earn income from the labors of others. The two quadrants on the right are the playing field of the rich and financially independent.
Moving from the left side to the right requires capital, education, and a new mindset.
The top two quadrants have your income from only one source, your job or your business. As such the top quadrants have limited income diversity and you, therefore, have a greater business risk and market risk. If the business you work for goes bust, your income stops.
Of course, if you in the “B” business owner quadrant and you design your business property, you will have multiple customers from multiple business sectors so you can mitigate much of the risk associated with income coming from a single company.
If designed properly, the bottom two quadrants have your income coming from multiple sources. As such, if a single customer or investment fails you have a diversity of income that will not cause you to lose 100% of your income.
Employee – Cash Flow Quadrant
When you are an employee you know you will get a paycheck as long as you continue to work for the business, even if the business is not profitable.
Earning a consistent wage each month is important when it comes to paying off debt, like home or car loans. However, full-time employees get their income from this single source, their job, and if they lose their job they lose 100% of their income. They have to rely on unemployment to bridge any employment gaps.
Moreover, in terms of Income taxes, employees pay the highest percentage of their income. The more you earn as an employee the higher your tax bracket, and you have few options to reduce your income through deductions or tax credits. Most Americans get their income from this quadrant.
Self-Employed – Cash Flow Quadrant
When you are self-employed, you own a job. The government also refers to this group as non-employer businesses, where the owner is the only employee. When you are self-employed you trade one boss for several bosses, known as your customers. While you have the flexibility to work the hours you want, you get paid only when you are under contract. The more you work, the more you get paid. There are no paid vacations or holidays for the self-employed.
Some self-employed individuals will derive income from several concurrent contracts, thereby achieving some level of diversification in their income. However, many self-employed workers simply work for a previous employer or for a single customer as a contractor and do not achieve any income diversification. In fact, many self-employed individuals have undertaken more income risk by becoming self-employed, with little if any additional compensation.
In terms of taxes, the self-employed person will have to pay the employer portion of FICA in addition to the employee portion, which is known as self-employment or SE tax on all taxable income. However, many business expenses such as cell phones, travel, etc. can be paid for using pre-tax dollars, providing the self-employed opportunities to reduce their taxable income. Savvy self-employed individuals price their services to adequately cover all their indirect expenses, including the additional employer-paid FICA share as well as any downtime experienced between projects.
Business Owner – Cash Flow Quadrant
Being a business owner is different from being self-employed in that as a business owner you have employees to do the work. That is not to say that the business owner does not work in the business also, but it means that they are getting paid for their effort as an employee in the business PLUS for being an investor in the business.
Business owners can scale up their business, which is not possible for the self-employed. As the business hires more and more employees a fraction of each employee’s bill-rate is the owner’s return on investment for the start-up capital, as well as for undertaking the additional risk of business ownership. As the business grows it generates more and more wealth for the owner. Like being self-employed, as a business
Business owners own systems that allow the owner to be absent for long periods and still generate income. Income diversification and taxes for business owners are similar to those of the self-employed. However, if the business is a corporation (S-Corp or C-Corp), not all income is subjected to the combined 15.3% FICA contribution, as is the case for the self-employed. For corporations, wages from working in the business are subject to FICA. However, the profit that is left after all expenses and salaries are paid is not subject to FICA.
Investor – Cash Flow Quadrant
The last quadrant is Investor. As an investor, it is all about having your money work for you. As an investor, you can spread your investment money around to achieve greater income diversification, while lowering overall risk through less investment concentration.
There is an investment continuum related to taxes. On one end of the
However, moving along the continuum, there are qualified dividends and long-term capital gains that benefit from special tax treatment. Rather than being taxed based on how much you make, these investment vehicles are taxed for most investors at a fixed 15% rate. One exception is for the
Next on the continuum is federal income tax-free interest income known as municipal bonds.
Beyond that, there is income from real estate, which allows for depreciation to lower taxable income. Further capital gains, which are normally taxed when the property is sold, can be deferred indefinitely using what is known as a 1031 exchange. This allows the investor to grow their assets without paying capital gains on each successive transaction.
Finally, there is direct participation in oil and gas programs. Investing in oil and gas programs allows the investor to write off most of his investment against other sources of income, such as wages. Also, a depletion allowance makes only 85% of the income subject to taxes. However, to play in this game, most investors need to be accredited. This means that they have a net worth in excess of one million dollars or earn in excess of $250,000.00 per year. To learn more about this asset class check out our sponsor Learn About Oil and Gas
What quadrant do you get most or all of your income from today? Is this the quadrant you want to continue to get all or most of your income from?
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